How Wall Street Collapsed--The Last Time

"Sometimes our technology, in creating these securities, outpaces our ability to cope with them." That's what Larry Fink told the New York Times in May 1987 when asked about Howie Rubin's trading disaster. In the past, Fink would have made that statement to a reporter and then celebrated with his team the fact that one of his competitors, particularly one like Merrill Lynch, which he saw as a pesky upstart in the field he aimed to dominate, was now being nailed with massive losses.

But Fink wasn't celebrating, because, much like Howie Rubin, he had just gotten his first real education in risk. And like Rubin, Fink and his team thought they had it all figured out. In the second quarter of 1986, Fink had made an opposite bet from Rubin--all of his research pointed to higher interest rates and a reduction of prepayments from mortgage holders, and he was having one of his best runs.

With that in mind, Fink began gambling even more with esoteric Collateralized Mortgage Obligation strips, and, like Rubin, he would end up losing big. Unlike in Rubin's case, the full extent of the losses wasn't immediately apparent. When the Rubin fiasco became public, Fink and his team thought they had their position hedged--meaning that they utilized a classic technique to reduce losses by making an offsetting trade, thus minimizing the losses that had beset Rubin.

But, as Fink was about to discover, his hedges were losers as well. His former boss Tom Kirch now worked for Fink and was attending an executive committee conference in Carmel, Calif., enjoying the beautiful northern California weather in the quaint town where Clint Eastwood was mayor.

During a break, Kirch went back to his hotel room and received an urgent message to call the First Boston trading desk in New York immediately. By now the Howie Rubin fiasco at Merrill was huge news; almost every other firm had taken massive losses as well. Fink figured that he was in the hole about $30 million, a manageable number given the countless millions he and his mortgage traders had made for the firm over the past six years.

But Wall Street has a short memory, and the bosses back home were fuming because the losses were bigger than anyone had expected. Apparently there was a glitch in Fink's vaunted computer system, the one set up specifically to crank out data for the First Boston mortgage traders, providing historical data for trades and keeping a record of gains and losses on those bets. In this case, the computers had miscounted the losses--by a lot; "they are bigger, much bigger than we thought," the trader in New York said on the phone.

Kirch felt a knot develop in his gut. "OK, I'll tell Larry," he said. Fink, who had been traveling, was now back in New York when Kirch gave him the report that their positions had blown up worse than they'd first believed. The losses were close to $100 million, possibly more.

"No fucking way" was Fink's response as he called his team, desperately demanding answers. He got the same report: Not only were the trades a bust, but the hedges had failed as well. Even worse, the evidence was clear that Fink's research was wrong; it had miscalculated the direction of the interest rates that were at the heart of Fink's losing trades and faulty hedges. The old Larry Fink would have called it being "whip chained." But the old Fink wouldn't have lost so much money. He was in fact being whipsawed, losing money on both sides of his bet, and he couldn't believe it, screaming at one point, "This can't be happening!"

As his staff briefed him on what had gone wrong--the failed hedges, the size of his position--Fink began to realize it was happening: The end of his world. Still just in his mid-thirties, Fink had been a rock star. His desk on First Boston's massive trading floor in midtown Manhattan had been the place to see and be seen. With his wild success, he had been on the fast track to run First Boston--just weeks earlier rumors had been spreading that he and mergers chief Bruce Wasserstein were about to be named co-CEOs. The chatter had picked up steam during the first quarter of 1986, when Fink's mortgage group had made a whopping $130 million--its best quarter ever.

But just like that, in little more than the blink of an eye, Fink lost $100 million in one quarter--his worst ever. The firm was bleeding red ink, losing millions and, combined with other losses, in need of an eventual bailout from the Swiss bank
Credit Suisse
, which increased its investment in First Boston to a controlling stake. With that came bickering, fingerpointing, and management changes. And the end of Larry Fink's career at First Boston.

In the weeks and months that followed, Fink kept going through it in his mind as he sat at his desk, staring blankly at the numbers on his computer screen. "How the fuck did it happen? How did I guess so wrong?" He couldn't come up with a reason, nor could he come up with an answer as to why he had made so much money in the past. Had it been luck or skill?

He'd used to think it was skill--that his knowledge of math and computers and his team of brilliant minds, including Ben Golub, the MIT financial whiz who could crank out differential equations in his sleep, gave him an insight into how complex new bonds and derivatives worked and an edge in understanding odds and beating the markets.

When Fink was on his way up, his ego had grown to massive proportions--being right for so long tends to have that effect. He loved to deride the competition, the risks they took over at Salomon. His archnemesis, Lew Ranieri, was a "cowboy" who didn't have a clue about risk, leveraging up and rolling the dice. Fink had always believed Ranieri was on the verge of a mammoth loss that would put him out of business. But now it appeared that Fink was every bit of a cowboy as Lew Ranieri or Howie Rubin. At least that's what had become readily apparent as the dust settled on his trades, showing that Fink had been trading in Rubin-like amounts--billions of dollars in volatile mortgage securities.

Fink had thought he knew everything there was to know about the mortgage bond--how to trade it, how to structure it to meet the tastes of investors and, most of all, how to gauge its risk. He had the best risk guy in the business, Ben Golub, and the best computer programs of the time. Golub, a soft-spoken MIT grad, had taken great pains over the past year to make sure the mortgage department had special access to First Boston's mainframe computer. In the past, the mortgage unit had had to share the mainframe and its measurement system with other departments. Golub had cut a special deal with First Boston's head of information technology, explaining to him that the hundreds of millions of dollars the firm had made in the mortgage market could be lost in an instant unless the mortgage department had access to the mainframe on an as-needed basis.

IT had agreed, and First Boston was considered to be on the cutting edge in employing technology to gauge the markets and predict its future course. But it wasn't enough. Fink immediately ordered a postmortem "so this will never happen again," as he told his group. Golub led the effort. His conclusion: As good as the computer systems were, they were obsolete compared to the size and scope of the market.

The system used by First Boston had been built to gauge and analyze the mortgage market of the early 1980s, not the trillion-dollar market it was now. It just couldn't produce data on a timely basis about prepayment rates and all the other variables that went into trading analysis. If First Boston was going to defy the odds, it needed a better oddsmaking system.

Fink had lost considerable standing in the firm, but he still had enough power to order a massive overhaul of the firm's risk assessment system. He assured his supervisors at First Boston that such trading losses would never happen again. But no one seemed concerned about the future. They were worried about the present, as the market for mortgage-backed bonds simply dried up; clients who previously couldn't get enough of them had suddenly had enough.

There was almost no price at which Fink could unload his positions. First Boston was stuck, and so was he. Fink had received not just his first real education in risk but also a lesson in how Wall Street really worked. Computers and mathematical models are only as good as the data that are fed into them; what they don't measure is the unforeseen--sudden and dramatic spikes or dips in interest rates and the once-in-a-lifetime gyrations that the oddsmakers tell us to ignore but history teaches us occur all the time.

Nearly a decade later, the author and mathematician Nassim Nicholas Taleb would describe what had happened to Fink in his book The Black Swan:The Impact of the Highly Improbable. In it Taleb explains why some of the most intelligent people on the planet fail to understand and appreciate the randomness of life as they cling to their statistics and computer programs, which were designed by the very same people.

"Alas, we are not manufactured, in our current edition of the human race, to understand abstract matters--we need context," Taleb wrote. "Randomness and uncertainty are abstractions. We respect what has happened, ignoring what could have happened. In other words, we are naturally shallow and superficial--and we do not know it. This is not a psychological problem; it comes from the main property of information. The dark side of the moon is harder to see; beaming light on it costs energy. In the same way, beaming light on the unseen is costly in both computational and mental effort."

Randomness was a lesson that Wall Street as a whole would fail to understand over the next two decades--only this time the losses would no longer be measured in "just" hundreds of millions of dollars.

Fink, of course, didn't have the benefit of Taleb's writings, and he was now paying the price. Colleagues who had used to kiss Fink's ass now regarded him as a pariah, the guy who had cost the firm millions and slashed the size of their year-end bonuses, the millions of dollars traders earn at the end of each year that are the payoff for their long hours sitting in front of computer screens. As soon as the bonus spigot was cut off, Fink was cut off from the rest of the firm. The cold shoulder began almost the moment news of the trading losses disseminated widely throughout the firm. Senior executives simply looked the other way when they saw him in the hall, Fink noticed, including Bruce Wasserstein, who had been somewhat of a mentor.

Others treated him worse. Like Fink, Joseph Perella, the flamboyant co-head of mergers at First Boston, often complained about the ruling WASP hierarchy on the Street. But if Fink was looking for Perella's shoulder to cry on, he was mistaken. At least Wasserstein still spoke to him on occasion. Perella acted as if he didn't exist.

Behind the scenes the executive committee wanted Fink out and his trading group dismembered. First Boston was too valuable an enterprise to be left to a bunch of gunslingers. It didn't matter how much money Fink had made in the past. On Wall Street you're only as good as your last trade.

Fink had worked at First Boston for a decade, through good times and bad. He had seen careers upended with one bad move--a lousy trade or a missed deal. He'd just never thought it would happen to him. His chances of running First Boston were over; his main goal now was to survive until he could either go on another winning streak or find another job. But First Boston wasn't the only firm that was reeling.